Arthur Okun's Answer to Inflation

NOTHING is more frustrating for economists than he everday proof that economic theory as it comes out of the graduate school laboratories doesn't match up with the real world.

For example, as everybody know, inflation soared into the double digits in the 1970s in the face of recession and high unemployment.

That wasn't supposed to happen. As the late Arthur M. Okun says in Prices and Quantities, a book he finished shortly before his untimely death in March 1980, "the plain fact is that no school of economists has a satisfactory theory of inflation." Neither those who place most faith in fiscal policy (Keynesians) not those whose religion is found in monetary policy (Friedmandites) had the answer, Okun says.

"Some insidious ratchet has gone into operation, giving inflation a far greater degree of persistence than it ever had beore. But who threw the ratchet in the soup?" Okun asks in this book. As you can see, Arthur Okun did not lose his sure touch for the catchy phrase that helped him put difficult economic concepts in lay language. That endeared him, as much as his brillance, to politicians and journalists alike.

But Prices and Quantities, which even before publication had been rated an important book by Okun's professional colleagues -- one that could conceivably earn him posthumous recognition by the Nobel Committee -- is not for the layman. It is a book that Okun designed to prove for his economist peers that his own theory for the persistence of inflation -- a theory that offers an explanation of why wage rates are "sticky," even when there is an excess of supply labor. "If Art had let us call it 'Causes and Cures for Stagflation,' it would have sold like hot-cakes," says his friend and Brookings colleague Joseph A. Pechman.

In effet, Okun contends in this book that neither price nor wages will decline as much as one might logically expect in bad times because of "implicit contracts" between customers and sellers, and between labor and management. In earlier writing, Okun referred to this phenomenon as an "invisable handshake": employers and employes recognize that they have a long-run investment in their relationships. To cut wages in a weak labor market would be penny-wise but pound-foolish. And even the ordinary consumer knows that there are costs in "shopping around," and thus often settles for a price that may not be the lowest available.

It is "the central theme" of the book, Okun writes, "that most prices and wages are not set to clear markets in the short run, but rather are strongly conditioned by longer-term considerations involving customer-supplier and employer-worker realtions. These factors insulate wages and prices to a significant degree from the impact of shifts in demand so that the adjustment must be made in employment and output."

This works well for companies and individuals, Okun argues, but for the economy as a whole, it raises problems. It means, in effect, that conventional balancing or tight money may be ineffective -- but may also slow down the economy or create a recession. That's why inflation and recession can co-exist, even if the textbooks say it's impossible.

But Okun and others had laid out the essential theme of all this by 1975. Why then, is this book creating the excitment that is palable in economic circles? Ralph Bryant, a Brookings colleague, explains that "it is a new and quite fundamental contribution to the literature, providing the analytical framwork [for his 'implicit contracts' theory]." Economist Martin Baily, who made his own contributions to the theory, told me: "Art's book is the best fleshing out of this new idea. It's got to be intellectually respectable for people to believe it and accept it. It hasn't been up to now, but I think this will contribute to it."

Pechman, who supervised the publication of the Okun manuscript, explains it this way: "Art probably would have cringed at the analogy, but before Keynes published the 'General Theory,' Keynes and a lot of others ahd been talking about public works as a remedy for unemployment. Now Art had been talking about cost reductions as a remedy for stagflation, but there was no system, there was no coherent body of economic knowledge that led up to that conclusion."

His wife Suzanne and his Brookings colleagues know that Okun intended this book to be his chef-d'oeuvre. Six of the eight chapters were fully edited, complete with biliographical notes. The last two chapters had been dictated, but not subject to Okun's own self-disciplined editing. But in a way, I think Okun's humanity and sense of social justice come shining through in the final pages. Okun was always at his best right off the top of his head, as any journalist who ever called him on the telephone knows.

Essentially, Okun was gloomy about prospects for dealing with inflation, foreseeing "a deep and prolonged recession," or a long period of rigid wage and price controls before the bubble breaks in this decade.

What he would have preferred (and admits is only a long shot) is a stategy far afield from what we are getting with Reagan supply-side economics. Okun would have supplemented a slow growth policy with a direct attack on wage-price costs including some form of social compact, or incomes policies -- that is to say, some direct government intervention in wages and prices.

Okun especially favored a "tax-based incomes policy" (TIP) as a middle ground between jawboning and formal controls. This would use the tax system to reward those complying with agreed-upon standards. He conceded the potential weaknesses, even dangers, of a TIP, but as a man of social conscience, he was willing to take the risk.

"What [citics] see as the danger of tampering," Okun wrote, "I see as the possibility for correcting an externality that no efficent system should tolerate . . . I would be mortally outraged by a local ordinance designed to promote fire prevention by prohibiting the fire department from responding to any alarms for a month. This is a strong analogy to attempting to prevent inflation by committing the government not to deal with a recession no matter how deep it becomes."